U.S. Sixth Circuit Holds that Customary Language in Amendment and Restatement Agreements May Extinguish Existing Security Interests via Novation

Financial Industry Alert

| October.14.2016

On August 23, 2016, the U.S. Court of Appeals for the Sixth Circuit held in the Chapter 7 bankruptcy case In re Fair Finance Company that an amendment and restatement of a loan and security agreement may have been a novation of the initial agreement and therefore extinguished the lender's existing security interest.

As background, in 2002, the lenders and the debtor, Fair Finance Company, entered into a loan and security agreement (the "Original LSA") for a $22 million revolving credit facility secured by substantially all business assets of the debtor. In 2004, the parties amended and restated the Original LSA (as amended and restated, the "Amended LSA"). The Amended LSA removed one of the two lenders, reduced the amount of the commitments, modified the fees and the interest rate, and re-granted the security interest in the business assets of the debtor.  The remaining lender did not file a new UCC-1 financing statement in connection with the Amended LSA, but later continued its UCC-1 filing under the Original LSA.

The Chapter 7 trustee argued that the Amended LSA novated the Original LSA, thereby extinguishing the security interest created under the Original LSA and rendering subsequent payments to the lender under the Amended LSA fraudulent transfers.  The district court rejected the novation argument, but the Sixth Circuit reversed, finding that the following provisions of the Amended LSA created a question of fact as to whether it was the parties' intent to wholly replace and extinguish (i.e. novate) the Original LSA and the security interest granted thereunder:

  • The statement that the Amended LSA was for "valuable consideration, the receipt and sufficiency of which are hereby acknowledged";
  • The language that the Amended LSA "constitutes the entire agreement of Borrowers and Lender relative to the subject matter" thereof and would "supersede any and all prior oral or written agreements relating to the subject matter"; and
  • The re-grant of the security interest under the Amended LSA.

It is cause for concern that all of the provisions the Sixth Circuit found were evidence of a novation in In re Fair Finance Company are regularly found in amended and restated loan documents throughout the broader loan market.

Significantly, the Sixth Circuit distinguished this case from In re TOUSA, Inc., where a district court ruled that the execution of an amended and restated agreement did not constitute a novation. The amended and restated agreement in TOUSA contained an explicit statement that the parties intended that the security interest and liens granted in the original security agreement would continue in full force and effect. The district court in TOUSA explained that notwithstanding the general language in the amended and restated agreement that all prior agreements were being restated in their entirety, the specific terms the parties agreed to must be given effect.

In light of the Sixth Circuit's recent decision, when entering into amended and restated loan documents, lenders should insist on clear and unambiguous language that the amended and restated agreement is not intended to novate the existing agreement. In furtherance of that stance, lenders should also require the borrower to reaffirm that the existing security interest continues in full force and effect.

The authors would like to thank Orrick Law Clerk Victoria Chu for her contributions to this piece.